Senate Bill 54: California takes one step further into sustainable finance

This October 8th, 2023, Gavin Newsom, Governor of California, signed into a law the Senate Bill n°54, or SB 54. The law will come into effect in March 1st, 2025, and aims to promote sustainable finance through diversity in venture capital (VC) companies by empowering historically underrepresented communities. Similar to the California Equal Pay Pledge of 2019, it is part of a political commitment to achieve gender and racial equality.

Venture Capital (VC) companies are companies or investment funds that usually invest in early-stage start-ups. Consequently, VCs drive innovation, economic and employment growth. In recent years, we have observed an increase in Socially Responsible Investment (SRI). This investment strategy consists in investors threatening to discard assets from the VC’s equity if it does not comply with corporate social responsibility standards. Hence, impact investing is limited to investors’ resources. These stakeholders cannot act alone towards an impact investing approach and sustainable finance. Regulators must promote sustainable finance throughout the investment chain. The California State Capitol attempts to do so through the SB 54.

The SB 54 provides more scrutiny on the policies conducted by VCs. The law targets “covered entities”, which is a VC company that: “(i) primarily engages in the business of investing in, or providing financing to, startup, early-stage, or emerging growth companies [; or] (ii) manages assets on behalf of third-party investors, including, but not limited to, investments made on behalf of a state or local retirement or pension system.”

Additionally, the VC company must: “(i) [be] headquartered in California [; or] (ii) [have] a significant presence or operational office in California [; or] (iii) [make] venture capital investments in businesses that are located in, or have significant operations in, California [; or] (iv) [solicit] or [receive] investments from a person who is a resident of California.”

Besides, the law prescribes duties to the targeted VCs, namely through a yearly survey reporting information related to its “founding team”. This targets owners of initial shares or interests of the company, a stakeholder who had an important role within the business before the issuance of initial shares or who is not a passive investor in the business, the chief executive officer, the president, the chief financial officer, the manager of the business, or any other stakeholder benefitting from the same level of authority.

Simultaneously, the VC must report information related to gender identity, race, ethnicity, disability status, and sexual orientation of the individual falling under the “founding team” criteria. The report shall also mention if that individual is a veteran or a disabled veteran, and if he/she is a resident of California. The person surveyed can decline to provide information, but the use of this right must be notified in the report.

Finally, the VC company must also provide “the number of [VC] investments to businesses primarily founded by diverse founding team members, as a percentage of the total number of venture capital investments the covered entity made.” Eventually, the results must be submitted to the Civil Right Department (CRD), a state agency that publicizes the data in a searchable database. Monetary penalties are prescribed for VCs who breach the provisions. The fine will be reinjected in the Civil Rights Enforcement and the Litigation Fund to enforce the Civil Rights laws.

This law is welcomed because it intervenes on a level distinct from that of the investors. It is an additional tool that must be used simultaneously with the investors’ room of maneuver. Here, the law targets the policies undertaken by the VC companies in their structure and thus, in their investment choices. Through the report and its publication, the law gives incentive for VC companies to include more diversity in their founding team. By doing so, it aims at easing the burden upon investors who favor ethical investments but are slowed down by the lack of capital.

Conversely, the law does not establish specific diversity standards for compliance; instead, it mandates the submission of a report. Consequently, VCs can potentially disclose a founding team composition lacking in diversity without facing direct consequences.

Yet, the law introduces an indirect incentive for increased diversity, as the annual report is made public. Accordingly, a VC company disclosing a lack of diversity in their data may experience a decline in stock prices. This decline could be attributed to investors prioritizing impact investing over mere profit gains. Hence, the responsibility for fostering sustainable finance ultimately rests on the shoulders of investors. In the end, this law must act as a stepping stone for future laws to provide solutions throughout the investment chain. For instance, regulators could set diversity standards for VCs to abide by, or nudge them to invest in a certain percentage of ESG companies.